Sep 19, 2018

Why We Need To Update Financial Reporting For the Digital Era

Value is increasingly more intangible than tangible. And financial reporting fails to capture it. That leads to misallocation of resources, misinterpretation of crucial data and misrepresentation of performance. JL

Vijay Govindarajan and colleagues report in Harvard Business Review:

Financial statements fail to capture the value created by digital companies. The market caps of Apple, Alphabet, Amazon, and
Microsoft exceed $3 trillion. Their combined assets of $944 billion
are an order of magnitude lower than the combined assets of the largest 3,177 companies in 1986. Financial capital is assumed to be unlimited, while human capital is in short supply. Risk is now a feature, not a bug. Investors are paying more attention to ideas and options than to earnings. Accounting is no longer considered a value-added function. Analysts increasingly rely on non-GAAP metrics. The market caps of just four companies, Apple, Alphabet, Amazon, and Microsoft, now exceed $3 trillion. Their combined assets of $944 billion are an order of magnitude lower than the combined assets of $7,700 billion of the largest 3,177 companies in 1986, when the aggregate market capitalization reached $3 trillion for the first time. In our recent HBR article, we argued that financial statements fail to capture the value created by modern digital companies. Since then, we interviewed several chief financial officers (CFOs) of leading technology companies and senior analysts of investment banks who follow technology companies. We asked: (i) what makes the valuation of digital companies more challenging?; and (ii) how can digital firms improve their financial reports to communicate sources of value creation in their businesses? We distilled seven key insights from those discussions. Some of these ideas contradict traditional financial thinking whereas others seem highly controversial or pessimistic.Financial capital is assumed to be virtually unlimited, while certain types of human capital are in short supply.
Business students have traditionally considered net present value, payback period, and hurdle rates as necessary tools to determine which project to select. These criteria assume a limited supply of financial capital and that prudent allocation of financial capital determines a firm’s success. Digital companies, however, consider scientists’ and software workers’ and product development teams’ time to be the company’s most valuable resource. They believe that they can always raise financial capital to meet their funding shortfall or use company stock or options to pay for acquisitions and employee wages. The CEO’s principal aim therefore is not necessarily to judiciously allocate financial capital but to allocate precious scientific and human resources to the most promising projects and to pull back and redeploy those resources in a timely manner when the prospects of specific projects dim.Risk is now considered a feature, not a bug.
Traditional valuation models consider risk to be an undesirable feature. Digital companies, in contrast, chase risky projects that have lottery-like payoffs. An idea with uncertain prospects but with at least some conceivable chance of reaching a billion dollars in revenue is considered far more valuable than a project with net present value of few hundred million dollars but no chance of massive upside. In light of this, an employee is evaluated not based on what she contributed to the company’s bottom line, but whether she identified a new, breakthrough idea.
This notion, that risk is a desirable feature, can seem like sacrilege to anyone who’s taken an introductory finance course. It’s unlikely that investors’ risk aversion has fundamentally changed. However, many investors seem to have concluded that the most successful companies with tens of billions of dollars of valuation today could never have justified their valuation at the start of their operation based on discounted cash flow. So, investors, and therefore managers, might be adjusting their approach to risk accordingly.Investors are paying more attention to ideas and options than to earnings.
Business students are taught to value a company based on the discounted amounts of future cash flows or earnings. That concept is becoming almost impossible to apply to emerging companies that are run as a portfolio of ideas and projects, each with uncertain lottery-like payoffs. CFOs of these companies themselves admit that they cannot justify their market capitalizations based on traditional metrics. They conjecture that their market values might be the sum of the option values of the projects undertaken, a sum of best-case scenario payoffs. One CFO said that her valuation should be considered on a per idea basis instead of a per earnings multiple.
In theory, options valuation should be able to handle this problem of valuing firms with lottery-like payoffs. In practice, we have yet to see a model that can justify, for instance, Amazon’s market capitalization. It’s possible that companies like those are overvalued. It’s also possible that we simply don’t know how to estimate the right parameters to make an options-based valuation work.
As digital technology becomes more pervasive, more and more companies will present this sort of valuation challenge. Given that even sophisticated investors cannot estimate the value of these companies, CFOs question the ability of a day trader to value a digital company. Therefore, companies see little value in disclosing the details of their current and planned projects in their financial disclosures, even if those disclosures can reduce the information asymmetry between investors and managers. Given the bull market in digital stocks, CFOs believe that they have no incentives to provide any additional information beyond mandatory SEC disclosures, which they consider excessive, tedious, and uninformative and might invite unnecessary scrutiny and litigation.Corporate venturing is becoming more important.
Many traditional companies realize the potential for disruptions in their business models from the likes of Alphabet and Amazon. However, they do not possess the infrastructure or talent pool to ward off potential competition. Furthermore, the operating managers cannot take their eyes off day-to-day operations to focus on innovation. Traditional companies therefore rely on two strategies. First, they create a new venture capital (VC) arm within the existing organizational set up. That VC arm is given relatively unconstrained financial capital to invest in innovation and disruptive ideas. Second, companies perform “acquihires,” — that is, the buying of a company primarily for its engineering and product design talent, instead of for its revenues or profits. Both strategies, however, create cultural incompatibility within the organization. For example, the legacy part of the organization is subject to tight fiscal discipline while the VC arm is given pots of money to bet on new ideas.Financial reporting requirements won’t change any time soon.
CFOs realize the growing limitations of the current financial reporting model. They are, however, extremely pessimistic about whether the model can be fixed within the current regulatory regime. One CFO commented that standard setters enjoy monopoly power and have no incentives to change their methods to be more responsive to investors. Another CFO mentioned that it will take a full-blown crisis, such as the 2000 dot-com meltdown, to force substantive changes in the standard setting process. In the meanwhile, companies increasingly resort to provision of proforma and non-GAAP reports, even though this practice is looked down upon by the SEC and is opportunistically misused by a few companies.Analysts increasingly rely on non-GAAP metrics.
As firms become increasingly difficult to value and more and more companies report negative earnings, analysts perform multiple adjustments to recreate companies’ financials in their internal assessments. For example, they capitalize a part of R&D expenditures that can enhance firm’s future competitive ability and deduct a part of capital investments that merely maintain firms’ competitive ability.Sadly, accounting is no longer considered a value-added function.
This is an outcome of the growing divergence between what companies consider as value-creating metrics and those reported as profits in the GAAP. Many CFOs consider financial reporting to be an exercise in mere regulatory compliance and find the resources spent on audits and financial reporting to be a waste of shareholder money. They consider the calculation of GAAP-based profitability to be more of a hinderance and distraction to their internal resource allocation decisions. One CFO commented that they now avoid inviting company accountants to their strategy meetings, while another said that CPA certification is considered a disqualification for a top finance position.
It’s clear to us from our research and from these interviews that the time has come for investor bodies and companies to rethink the financial reporting model from scratch. For instance, standard-setters might want to encourage disclosures related to (i) value per customer; (ii) earnings or revenue outcomes or other specific metrics related to specific projects in progress; and (iii) data on how the R&D and software talent of digital firms is being deployed. Relying on firms’ voluntary initiatives is unlikely to work because executives told us time and again that they will not disclose sensitive information, unless their competition is forced to do the same.

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As a Partner and Co-Founder of Predictiv and PredictivAsia, Jon specializes in management performance and organizational effectiveness for both domestic and international clients. He is an editor and author whose works include Invisible Advantage: How Intangilbles are Driving Business Performance.Learn more...